BREXIT 3 – the decision

A small majority of UK voters have chosen to ‘leave’ the EU.  Now we will reap the economic deluge in terms of financial market shocks, lower investment and fewer jobs.  It will take a few years for the negotiations to assert some certainty back on the future path of trade and exchange.  It will take longer for the negative effects on inward investment to work themselves out.  The UK economy will be weaker than it otherwise would have been for up to a decade.  The SW economy will be poorer as key factories and facilities across the region are sidelined or lost, many household incomes are reduced and fiscal transfer resources are diminished.

The question, then, is how we respond to and mitigate these choices and negative effects.  The next Prime Minister, as well as negotiating with all our partners, has to instigate policies that will increase investment, raise productivity and drive development whilst dealing with the probable break up of the United Kingdom.  Hopefully, by 2025-30, we can look back and say “well, it was a painful adjustment but we did it and now the future looks bright again for England” (alone?).  Today, it’s hard to look ahead with confidence but the hard work starts now.


In 2016/17, there will be a UK referendum on whether or not to stay in the EU.  Most of the arguments, particularly currently espoused about what PM Cameron might secure in terms of EU reform, are political.  What about the economics?

  1. In or out, it won’t come cheap.  Some EU-sceptics talk about repatriating funds from the EU worth £50mn a day.  Dream on – that’s gross and the costs of extracting UK from all the current arrangements will cost money.  If there is no Common Agriculture Policy or development funds for Cornwall, do you think the UK government will do nothing to soften the blow for those affected at home?  Just think how much money the lawyers are going to make from re-writing contracts and how many civil servant/ bureaucrats we’ll need to make the change…  It could easily take five years to extract the UK from current contracts and processes and replace them with new ones.
  2. Meanwhile, there will be an investment strike.  If you are a foreign-owned multinational based in the UK, faced with great uncertainty as to the vote and its eventual result, at the very least, you’ll 1) wait and see or 2) you may re-direct investment to facilities still likely to be in the EU or low-cost centres elsewhere and, at worst, 3) you’ll close UK operations and supply the UK market from continental Europe – with potentially disastrous consequences for UK exports  and productivity.
  3. UK borrowing costs and sterling volatility will rise and fiscal. management may be disrupted, at least in the near term.  This will also encourage overseas rather than domestic activity – investment, employment and trade.  Again, uncertainty and borders restrict exchange and wealth creation.
  4. Migration flows will shift – unpredictably.  The UK recovery has benefited from net migration over the last few years – this could reverse, again with a short term negative economic shock and, perhaps, wider politico-social (e.g. NHS) effects.
  5. In the long run, however, it is quite feasible for a good relationship to emerge between an outside UK and an ‘ever closer’ EU, as it does for Norway, Switzerland, et al.  In a decade or so, no economist, let alone politician, can tell you whether we’ll be better or worse off in or out of the EU especially if, as a result, Scotland becomes an unreliable, one-party, independent state.  All we can say is there will be winners and losers and it won’t be easy to spot who will be which, bar the usual suspects.

    The economic issue for me is the short term – by which I mean 3- 5 years after an ‘out’ vote.  BREXIT will cost the UK a lot of economic activity and potential that it might otherwise haveBREXIT still might be the right political and social choice for our island race.

    I only hope the forthcoming debate makes the real costs and benefits of the two options clear to us all in great detail before we get to the actual vote.


Greece has a debt habit which is now completely debilitating.  Further bail outs will only feed the habit and help neither the patient nor the doctors.  The condition has been left untreated so long that there is no longer any easy way out without drastic, painful surgery, especially for the ordinary Greeks.  Sadly, the referendum was irrelevant and Grexit now looks inevitable, whether it comes sooner or later.  It will be a bad example for others – yes, there are some important moral hazard issues for other debtors – but, the euro-zone (EZ) (and Greece) will be better off eventually if it reduces to a sustainable size and structure.

There are many historical examples of default and creating new currencies, especially in what used to be called the third world, then developing countries and now …?  Argentina 2001/2 stands out in my memory but there are many others and some companies and individuals go through bankruptcy all the time.  It is awful to live through but, in the end, there is no choice but to wipe the slates clean and start again.  Countries are not immune to the perils of insolvency if they adopt the wrong incentives and economic cultures.  Sadly, the Greek government’s approach is popular but populist.  It is not helping.

For rest of us, bottom line is Greece is not big (2% of EU GDP?).  As Brian Wesbury of First Trust Portfolios says, Greece going bust in EU is equivalent to Detroit going bust in the USA.  It is manageable and does not matter for overall macro trends.  It needn’t derail the overall economy as long as the markets don’t overreact.  Of course, some EU businesses will be affected badly and wider contagion is a risk but, of itself, it’s not a big economic issue – even if it’s politically toxic.  This should not have been as difficult a problem as the Eurozone has made it.

The path out requires 1) Greece to adopt growth-friendly policies, including fiscal tight and monetary loose stances and, importantly, legal structures and regulations that re-affirm trust in the system of property rights, payments and due process; 2) some debt write-off by EU/IMF and banks with strict conditions about future behaviour (30-50%); 3) some time-limited liquidity support for Greek banks; and 4) a new currency that can depreciate and improve Greek international competitiveness albeit at the cost of higher domestic inflation.

Easy to write – not easy to live through.  There but for the grace of God go us all.  Have other large debtors, including UK, learned the lesson?  This takes us towards Osborne’s budget later today … more on that later.


European Stagnation

This week’s news that Germany’s economy declined in the latest quarter, that France’s economy was flat and that Italy’s economy was again in recession emphasised the fragility of growth in the eurozone.  Across the continent, consumption, investment and exports are all suffering from weak demand fundamentals and the economy is stagnating.  High debt burdens, weak real incomes and severe unemployment are all affecting confidence and restricting spending.

Moreover, the policy approach seems ineffective in terms of generating growth, with a classic ‘liquidity trap’ in monetary policy meaning that low interest rates are of no use in stimulating activity and fiscal policies largely constrained to reduce deficits and pay down debts.  There is speculation that, as the UK and US withdraw from their programmes, the European Central Bank will have to resort to quantitative easing sooner rather than later in an attempt to offset European stagnation.

This background implies a negative influence for the UK economic upturn.  Although the home economy has had a robust first half, with output finally moving slightly higher than the 2008 peak, it may be difficult to maintain that momentum when the UK’s major export markets are stagnating.  Furthermore, since the UK imports many intermediate and final products from Europe, its relatively high growth implies a worsening trade deficit (already far too high) and, hence, a bigger drag on growth.

The failure to rebalance the economy towards an investment-led recovery over the last five years of downturn means the United Kingdom remains vulnerable to weak growth amongst its neighbours.   Other things being equal, the lack of growth in the eurozone means a slowing of the UK recovery in the months ahead.  Unless domestic demand offsets this factor, which seems unlikely given weak real incomes at home, this reinforces expectations that the UK economy will grow at a slower rate in 2015 than in 2014.


New Kid in “Development” Town

The BRICS (Brazil, Russia, India, China and South Africa) have announced that they will set up a “New Development Bank” (NDB) to fund economic development in their countries. The aim is to start with US$50bn of equal contributions in an infrastructure loan fund, to grow that over time, and to establish a US$100bn Contingency Reserves Arrangement for handling financial/payments crises.

The NDB stems:
i) partly from a frustration with the lack of reform at the World Bank/IMF nexus in recognition of all the comparative and absolute economic change of the last few decades and
ii) partly from a positive desire to develop new funding streams for the growing networks of economic interaction between and across the “south”.

The stated intention is that other ’emerging’ economies could contribute to and benefit from the NDB over time.

The NDB might well be an inherent ‘good’ for these countries and their partners.  Anything that potentially supports sound, value adding, infrastructure development could be very welcome. There are, however, five main issues that will need to be addressed.

1. Politics – how will the institution affect geopolitics?  It could be highly divisive, adding to the worrying strains (Ukraine) that already exist between ‘north’ and ‘south’?  Also, are these five contributors politically stable and aligned enough to be able to pursue their goals efficiently, effectively and honestly or are they going to fall out over the real world application of their aspiration?  There is a danger that the economics will be abused with the politics.  Rule of law and a ‘free trade’ approach are vital ingredients to successful, long-term, economic development.  Sadly, some BRICS do not always display these characteristics well.
2. Economics – the countries involved vary so much in the scale and scope of their investment processes.  South Africa is in a much smaller, poorer and vulnerable economic state than the Chinese global behemoth.  Moreover, they are competitors as well as partners – can they manage the stresses these differences will imply?  One member’s priorities could be to another’s disadvantage without fair procedures for handling disputes over aims and method.  The NDB will need careful management of internal expectations.
3. Finances – why is the pooling of this money better than the spending of it individually? Will the infrastructure that is produced be better or worse (economically, in terms of productivity enhancing skills and investment locally, as well as physically) as a result?  How will they handle the letting of contracts? There is a danger of circularity here: India donates funds to the NDB which is spent with Indian companies on Indian projects – why set up an institution in Shanghai to act as a ‘middleman’ in this?  Why not do it yourself? I n essence, why would the sum of these parts make for better outcomes than the individual pots?  There is a risk that projects end up taking longer and are more expensive than they could be.
4. Technicals – who is going to do the appraisal and evaluation of investment proposals and outcomes?  There is a need for robust monitoring and surveillance of the projects and the funds. They will need high paid, highly qualified, experienced, objective, analytical researchers, economists, planners and developers.  This could mean that all the problems of an expensive bureaucracy, with the potential for corruption, will emerge during the institutional ‘learning’ phase.  There is a risk that they will want to show quick but suboptimal results.
5. Relationships – is the NDB set up in competition or partnership with the IMF/WB and other bodies?  Will it lead to separate funding streams that are vying for the same or similar projects, risking duplication or inefficiency?  Competition may be good between competing developers but it can also be divisive and, ultimately, ineffective.  Is China going to act as guarantor as, effectively, the USA has done for the Bretton Woods institutions for nearly 70 years?  How will the existing institutions now evolve – decline, disappear or be revitalised into more of a ‘developed’ world club?

At this point, we can not answer these questions. Good intentions now need to be backed up with practical implementation. We will need to watch closely as the NDB is born, grows and struggles for maturity.

Interest (ing) Rates

The ECB (0.25%), Bank of England (0.5%) and Federal Reserve (0.25%) are all keeping base interest rates at very low levels.  Most forecasters expect them to stay that low through 2014 and only rise a little in 2015.

In evidence to Parliament this week, on the fifth anniversary of UK base interest rates being so low, Governor Carney of the BoE said we should expect official rates to rise over the next few years but very slowly – perhaps up to 2%.  Through its own “forward guidance”, the Fed is also preparing Americans for gradual interest rate increases but nothing that should “scare the horses”.  Indeed, if they leave it too long, there seems more risk of new “credit bubbles” than of “killing growth”.

All businesses and consumers in America or Britain should be planning for slightly higher interest rates in the next few years.  However, none of this should threaten the recovery because interest rates will still be a lot lower than the historical ‘norm’.  Also, loan margins over base are already wide and should be able to accommodate this nudge in base rates without any need to move for current borrowers.  Indeed, my own view is that the increase in base rates could come sooner because it will be beneficial for prolonging an upturn, if only because it will start to provide some incentive for savers and investors to fund further development.

There is now a debate as to what ‘normal’ rates of interest are.  The historical argument, for example, is that UK base rates tend to move around 4.5-5.5%; made up of 2.5-3% trend potential of real growth and 2-2.5% of underlying inflation.  The ‘new’ argument, however, is that the prolonged downturn has changed the game fundamentally and the new ‘normal’ will be permanently lower, perhaps 3.5-4.5%.  My immediate reaction is “nothing is permanent” in the economy but let’s look at the arguments for lower interest ‘norms’ for the foreseeable future.  (David Miles, a member of the MPC, has developed these arguments in a recent speech – see BoE website for link.)

First, it is suggested there is a changed concept of ‘safe return’.  Simply, the ‘great recession’ has shown that the authorities will do anything to prevent depression and deflation/inflation and, therefore, the risk-free (UK gilts?) interest rate can be lower.  Second, there is the argument that the real trend rate of UK growth is going to below: a) because of the damage to growth potential of the long downturn itself and b) because of the long-term effects of the ageing population.  Third, the spread between ‘risky’ and ‘safe’ interest rates has permanently widened.  For most of us, lower base rates does not mean lower loan rates and the margin of association between the two has widened.  Fourth, the BoE balance sheet is much bigger – high supply means money stays cheap.  Fifth, perceptions of catastrophe have changed: the fear of new negative ‘shocks’ will keep a ceiling on rates.

It does seem likely that aspects of these factors will restrain base interest rate increases for several years.  I do not believe it can last forever, however.  At some point, assuming no catastrophic events, a sustained upturn will deliver some resurgence of growth and inflationary expectations.  Perhaps, we can ignore this for some time – probably, at least three years.

Moreover, in Europe, the  balance of risks are still the other way.  Deflation, especially in the debtor parts of the euro-zone, is a real concern.  Today, Martin Wolff of the Financial Times has talked about the zone being “one shock away from deflation”.  This is much scarier than the risks of higher interest rates in the anglo world.  The ECB need to watch this closely and learn from Japan’s experience since the 1990s.

Remember the Americans

In the last couple of weeks, we’ve all heard about the shutdown in parts of the US public sector following the failure of Congress to pass a budget.  A number of people have asked me, “So, what does all this stuff in America mean for us.”  Here, I try to highlight the main themes and risks.

Each year, the executive (President Obama’s government) sets out its budget plans and the legislature (Congress) debates and amends it and then votes it through for the Presidency to sign into law.  But, the Senate and/or the House of Representatives, particularly if they have a majority vote for the ‘other’ party (as the House does currently), often table their own budget proposals.  Over the spring/early summer, the different options are argued about, within and between the two parts of Congress, and negotiated with the Executive.  Usually, a single united budget for the next year is set, voted through and signed off before they all go away for the summer… well ahead of the end September deadline.  This year, following the split 2012 elections and the desire of the “tea-party” wing of the Republicans to reverse or delay “Obamacare”, the sides failed to agree by the deadline,  causing the shutdown.  Without a renewed mandate from Capitol Hill, the Executive had no authority to spend on about one third of its current activity after 1st October.

More importantly, America is also approaching its debt ceiling.  Congress sets an absolute US$ amount of debt (government bonds) that the Executive/Treasury can issue to finance US government spending.  Every few years, through the process of growth, inflation and political largesse, Federal America comes up against this ceiling and a higher one has to be approved.  Often, this is a formality but, with the Republican majority in the House wanting to force the Democratic Presidency into more debate about cuts to government spending, not this year.  The next deadline is on or around17th October because that is when the government starts to run out of cash and may not be able to roll over its debts falling due.

Whatever the rights or wrongs of the politics, there are potentially significant economic ramifications for us all if these two matters are not resolved speedily.

  • The immediate effects of the shutdown are relatively minor.  It could shave a few percentage points off US GDP growth directly through the cut in government spending and indirectly through supply chains effects and lower consumption by the federal employees who are not being paid.  But, assuming the furlough is brief (the last and longest was for 3 weeks nearly two decades ago under President Clinton), the effects of the shutdown should be made up before Christmas.   If it were to persist for longer than expected, it would lower US growth this year.  Trade and financial flows would be reduced and the dollar might slip, affecting our exporters and investors. But, again, the lost ground should then be made up in 2014. Although some US individuals and activities can be badly affected in the near term, shutdowns cause little or no damage to the overall macro economy.  Indeed, by focusing public attention on the scale of government, they can have a positive side effect – restricting the rise in federal spending relative to GDP growth over the medium term.
  • Although, again, it depends on how long it lasts, the effects of the debt ceiling barrier are potentially more serious.  Not being able to borrow would affect US spending much more significantly.  It could hit confidence hard, hurting investment and hiring decisions, stock market valuations and the currency.  Moreover, if there was an actual default – a failure to roll over existing US treasury bill or bond debts – the damage to global markets could be severe.  The risk or reality of a default by the world’s biggest debtor – allegedly a ‘safe haven’ – could start a shock wave of distrust that would overwhelm anything we have seen with Spain, Greece, Italy, Cyprus, Portugal or Ireland.  Frightened of losing funds that they thought were safe in America, investors would sell off other non-US assets to recoup liquidity.  In the rush for the exits, many banks would face a fresh and possibly large credit crunch.  Moreover, with monetary policy makers already setting interest rates as low as possible and many treasuries fiscally strapped, the room for counter-action is severely constrained.  Few economies would be safe from such a tsunami.

If the worst happens, the Treasury would run out of cash in about a month, forcing spending cuts worth an estimated 4% of GDP and starting another US recession.  For a while at least, the Federal Reserve can print even more dollars to pay off US$ loans.  But, that would devalue the monetary base and the currency, leading to higher inflation and other economic problems down the line.  There is little doubt who would get the blame – are US politicians suicidal?.  Surely, an actual default will be avoided.

What is happening between the two ends of Pennsylvania Avenue in Washington may seem a long way from your economic life but, if they mess it up, 2008’s credit collapse will be written about as merely the first stage of a deeper and longer malaise in the world economy.  2013 could become the new 1929 and our economy, businesses and jobs, could not remain aloof from such a catastrophe.

Surely, they are not that stupid.  I expect this will all be settled in a few weeks and this blog will pass into myth and legend – at least, until the next time we approach a political impasse.  There could even be an upside to this crisis.  If it forces a real, non-partisan debate about the state of the US public finances and their relationship with the private economy, it could result in a better outcome for us all.  To paraphrase Winston Churchill (and Stephen Stills), “remember the Americans will try all the wrong things before doing the right thing”.

Productivity … further from the Holy Grail

The latest international comparisons on productivity show the UK’s relative position weakening in 2012.  Output per hour and output per worker were 16 and 19 percentage points respectively below the G7 average.  The ONS says the former was the largest gap since 1994.  Unlike most of its peers, UK productivity was lower in 2012 than in 2011.

In current prices, last year, UK output per hour was 29 points behind the USA and 24 points behind Germany and France.  In terms of GDP per worker, the equivalent gaps were 40 points and 10-11 points.  The large relative US differential between these measures (40-29) is explained by its longer working hours whereas the opposite is true in Europe (10-24).

In constant prices, UK productivity remained below its 2007 peak in 2012 and slipped back relative to its rivals and, significantly, compared with its own previous long term trend.  Here is the real cost of the UK downturn.  We are less competitive, buying a less negative employment impact at the price of poor productivity.  I am not saying this is right or wrong.  It just is.  In contrast, the USA and Canada in particular, have seen a more normal pattern of productivity and employment fall and rebound over the downturn.

Why does this matter?  It matters because productivity growth is the ‘holy grail’ of economic performance.  It is what underpins future living standards.  If our relative productivity performance is slipping and our absolute productivity is not increasing, relative living standards will fall over time and absolute, post-inflation, living standards will, at best, stagnate, and probably drop.  In turn, this means lower employment and real incomes, and higher unemployment down the line.

Many don’t get this.  “Surely,” they say, “productivity destroys jobs.  The easiest way to increase productivity is to sack people.  I think it’s better to have high employment than high productivity.”  This confuses the micro and the macro and the short and medium term.  For an individual firm, it may be that shedding labour will boost productivity – for a while.  In an upturn, this may be because new technology is adopted which raises output per hour/worker and less workers are needed to produce the same level of output.  In a downturn, this may be because demand has slumped and the current output level needs fewer staff.

But, in the first case, the new investment should make the company more profitable and more competitive.  It will be able to enter new markets, develop new products and increase its market share.  In the medium term, this growth will lead to a need for more staff as the company grows.  The chain is from productivity to growth to jobs.

In the second case too, shedding staff can turn things around by releasing resources that can be redeployed to better effect elsewhere in the economy and by turning round financial positions to the point where more positive trends can emerge.

In the medium term, productivity growth is a generator of jobs, especially at a macro level.  If everybody sacks workers to boost productivity, demand will fall and the economy will shrink and productivity will then drop again.  But, if everybody raises productivity, it will raise spending power, start to increase demand and hiring across the whole economy.

The bottom line here is that the UK recovery will not be sustained and secure until productivity starts to climb again, in absolute and relative terms.  In the short-term, this may restrict employment growth but, later, once we have got on to a productivity-led growth path, the increases in employment will come.

Politicians and commentators have been talking about rebalancing the UK economy to make it more internationally competitive for the long run.  My argument is that the crucial element is for it to be investment-led in a way that boosts productivity.  The latest productivity figures are awful and current policies are not really helping.  Let us pray that the UK political parties go into the 2015 election with productivity boosting policies at the ready.  Fundamentally, this probably means getting out of the way of entrepreneurial drive, innovation and skills acquisition.  The search for the ‘holy grail’ of productivity is paramount to a sustained upturn.  Unfortunately, right now, unlike our competitors, we are going in the wrong direction.  Until, we turn around, the recovery can only be weak and vulnerable to shocks.


Fed leadership change should not delay Fed policy changes

The US President’s/Congress’s decision about who will replace Ben Bernanke as Chairman of the Federal Reserve next year is very important for us all.  Indeed, several other key members of the Federal Open Markets Committee (FOMC) are also leaving.  Such great policy and institutional uncertainty is never welcome.  In the end, the status and direction of US monetary policy is a key determinant of market performance in finance and trade as well as the pace and direction of economic growth and inflation across the globe.

Since the credit crunch of 2007-9, the accommodative stance of the Fed’s approach, with very low interest rates and aggressive creation of money, has been a key ingredient of avoiding depression.  It has done this at a cost of prolonged economic malaise and a risk of higher inflation in due course.  The question now is whether the transition of leadership postpones the necessary adjustment of monetary policy back towards a ‘normal’ yield curve and money supply growth/ratios.  Then, the issue is whether the pace and scale of adjustment is appropriate.

It is a difficult task to end ‘Quantitative Easing’ efficiently and effectively.  This week, the Fed may start to taper QE3 down from US$85bn a month.  This passing of the peak in monetary stimulus would be a key, symbolic and real event.  In anticipation, markets have started to price in higher long-term interest rates and their effects on future growth in some emerging markets.  The process of adjusting the Fed’s balance sheet downwards is crucial for macroeconomic development and prudential adjustment.  (The Fed’s balance sheet has reached a massive US$3.7 trillion compared with US$1 trillion before the recession.)

The Fed is convinced the various stages of QE have supported growth since the crisis.  There is an argument, however, that it has also constrained recovery.  The switch from QE to ‘forward guidance’ is now underway in many central banks, including the United Kingdom: ‘full employment’ is a policy signal/goal as well as inflation, (although this ‘dual’ target is debatable in theory and practice).

We all need a clear signal of how the leadership is to move at the Fed but, more importantly, we need a clear sign of future policy direction.  It is to be hoped that the Fed leadership change will not delay the necessary Fed policy changes.

Germany to win the Euros but leave the euro?

Germany beat Portugal in the group stages of the Euro football championship currently underway in Poland and Ukraine.  They beat Greece in the quarter final.  They may well face Italy in the semi-final and Spain in the final.  By the end then, Germany may have beaten all four representatives of the Mediterranean’s economic basket cases and won the cup.

In the euro-zone (EZ), Germany also appears to have the upper hand.  The question not really considered, however, is whether Germany will leave the EZ before any of the Medi-debtors.  Some sort of divorce now seems inevitable.  Divorce is messy and both partners may well end up poorer as a result but, sometimes, it is better for the long run.

Germany has gained competitiveness by being tied to its EZ partners: lower transaction costs to trade.  As an exporting country, it won’t want to throw that “access to markets” away lightly.  However, if those markets stay depressed for years and it has to pay unpredictable – in quantum and over time – subsidies to countries over which it has no political control, the net benefits of the EZ may well seem less.  How long will Germany be willing to pay higher taxes and use a debased currency with higher inflation than it could have on its own to support the social welfare schemes and uncompetitive practices of other nations?

The Euro-Meds have gained lower interest rates from being tied to Germany and, over time, this could/should have allowed them to invest in productive efficiency.  But, with different fiscal and regulatory structures and cultures, that potential benefit has been squandered and led to the current financial morass.

For Germany, with strong exporting companies and reasonably low unemployment, this is as good a time as any to go its own way – get a stronger currency that means cheaper imports, lower euro-debt maintenance, and enjoy overall lower inflation whilst not paying for others’ profligacy.

There are other factors, not least the interwoven banking effects and the political will to build a deeper European family.  But, the economics could see Germany walking away with the cup.